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14-2 



[COMMITTEE PRINT] 






TAX REVISION ISSUES— 1976 
(H.R. 10612) 



5 



TAX TREATMENT OF FORJB£QS£^NI) 
EXPORT INCOME 



Prepared for the TXsi? Of the 

COMMITTEE ON 

BY THE STAFF OF THE 

JOINT COMMITTEE OX INTERNAL REVENUE 
TAXATION 





APRIL 14, 1976 



U.S. GOVERNMENT PRINTING OFFICE 
WASHINGTON : 1976 



JCS-12-76 



Digitized by the Internet Archive 
in 2013 



http://archive.org/details/taxissueOOunit 



CONTEXTS 



Page 

Introduction 1 

1. U.S. taxation of foreign income — an overview 1 

2. Tax deferral 6 

3. Foreign tax credit 9 

Credit limitations 11 

Less developed country corporations 12 

Treatment of capital gains 13 

4. Amounts primarily affecting individuals 15 

(A) Exclusions for income earned abroad 15 

(B) U.S. taxpayers married to nonresident aliens 16 

(C) Treatment of foreign trusts and excise tax on transfers of 

property to foreign persons 17 

5. Money or other property moving in or out of the United States 19 

(A) Investments by foreigners in the United States 19 

(B) Treatment of reorganizations involving foreign corpo- 

rations 20 

(C) Contiguous country branches of domestic insurance 

companies 22 

(D) Transition rule for bond, etc., losses of foreign banks 23 

6. Special categories of corporate tax treatment 24 

(A) Western Hemisphere trade corporations 24 

(B) Corporations conducting business in possessions 25 

(C) China trade act corporations 27 

7. Domestic international sales corporations 29 

(Hi) 



INTRODUCTION 

This pamphlet presents background information on a number of 
proposals designed to modify the tax treatment of foreign or export- 
related income. The proposals described here are those which were in 
the House-passed bill (H.R. 10612). There are, of course, other pro- 
posals relating to foreign or export income which could be considered. 
Subsequent pamphlets will discuss other proposals as well as alterna- 
tives and possible modifications to the proposals presented here. 

This pamphlet first presents an overview as to the taxation of 
foreign income, including a brief discussion of the general prin- 
ciples employed in different countries in taxing foreign income. This 
is followed by a discussion of tax deferral, possible modifications in the 
foreign tax credit, three modifications made by the House bill in the 
tax treatment of individuals with income earned abroad, possible mod- 
ifications of provisions in present law affecting money or other prop- 
erty moving in or out of the United States, possible modifications of 
three corporate categories receiving special treatment, and finally a 
discussion of Domestic International Sales Corporations (DISC) . 

In each of these cases the pamphlet describes present law and the 
issues which have been presented. The House provisions, to the extent 
they bear on the problem discussed, are also described briefly. As indi- 
cated above, subsequent pamphlets will discuss alternative proposals 
for dealing with these problems. 

1. U.S. Taxation of Foreign Income — An Overview 

General Principles 

There are two generally recognized bases for any country's jurisdic- 
tion to tax income: (1) jurisdiction over the recipient of the income, 
and (2) jurisdiction over the activity which produces the income (i.e., 
the source of the income). Thus, a country may tax the worldwide 
income of persons subject to its jurisdiction or it may tax income earned 
within its borders, or it may tax under both standards. 

Tax jurisdiction over an individual may be obtained, as in the 
United States, by the residency or citizenship of an individual. Tax 
jurisdiction over a corporation is determined by place 1 of residency, 
which in the United States is the place of corporate organization. 

In addition, most countries' tax laws and regulations contain rules 
(called source rules) for determining whether, and the extent to which, 
income is considered as earned from .activities conducted within that 
country or within some other country. 

(1) 



Since most sovereign nations apply one or both of the above prin- 
ciples in taxing their residents and in taxing income from sources 
within their borders, two nations often claim the right to tax the same 
income. Most nations have developed principles to accommodate these 
competing claims and thus avoid what could be called a double taxa- 
tion of income. One principle is that the country of the source of 
income has the primary jurisdictional right to tax that income. In this 
case the country of residence retains a residual right to tax that income. 
Since a double tax on this income would tend to discourage capital and 
individuals from crossing borders and thus would inhibit international 
commerce, most countries which exercise the residual right to tax their 
residents and corporations on a worldwide basis allow a tax credit for 
income taxes paid to the source country. 

U.jS. Treatment 

Under present law, the United States imposes its income tax upon 
the worldwide income of any corporation organized under the laws of 
the United States, whether this income is derived from sources within 
or from without the United States. 1 A tax credit (subject to limits) is 
allowed for foreign taxes imposed on foreign source income. 

Foreign corporations generally are taxed by the United States only 
to the extent they are engaged in business in the United States (and 
to some extent on other income derived here) . As a result, the United 
States generally does not impose a tax on foreign income of a foreign 
corporation even though it is owned or controlled by a U.S. corpora- 
tion or group of U.S. corporations (or by U.S. citizens or residents). 
Such a corporation is subject to tax, if any, by the foreign country or 
countries in which it operates. Generally, the foreign source income 
of a foreign corporation only will be subject to U.S. tax when it is 
remitted to the corporate or individual shareholders as a dividend. The 
tax in this case is imposed on the U.S. shareholder and not the foreign 
corporation. The fact that no U.S. tax is imposed in this case until 
(and unless) the income is distributed to the U.S. shareholders (usually 
corporations) is what is generally referred to as tax deferral. 

There are, however, exceptions to the general rules set out above 
where income of a controlled foreign corporation is taxed to the U.S. 
shareholders, usually a corporate shareholder, before they actually 
receive the income in the form of a dividend. The procedures (subpart 
F of the code) set forth in present law treat certain income as if it 
were remitted as a dividend. Under these provisions income from so- 
called tax haven activities conducted by corporations controlled by 
U.S. shareholders is deemed to be distributed to the U.S. shareholders 
and currently taxed to them. 

Under present law, a U.S. taxpayer who pays foreign income taxes 
on his income from foreign sources is allowed a foreign tax credit 



1 Exceptions to this general rule are provided for corporations which 
primarily operate in the possessions and for DISCs. Also, a reduced 
rate of tax (34 percent) is provided for Western Hemisphere trade 
corporations. 



against his U.S. tax on his foreign source income. The credit is pro- 
vided only for amounts paid as income, war profits or excess profits 
taxes paid or accrued during the taxable year to a foreign country. 
This foreign tax credit system is based on the principle that the coun- 
try in which business activity is conducted has the primary right to 
tax the income from that activity and the home country of the indi- 
vidual or corporation has a residual right to tax that income, but only 
so long as double taxation does not result. While some countries, such 
as France and the Xetherlands, avoid international double taxation 
by exempting all income from foreign operations, most of the other 
industrial nations — including the United States, Great Britain, Ger- 
many, Canada and Japan — use the credit system to avoid double taxa- 
tion of income. 

The foreign tax credit is allowed not only for taxes paid on income 
derived from operations in a specific country, but it is also allowed 
with respect to dividends received from foreign corporations operating 
in foreign countries and paying foreign taxes. This latter credit, called 
the deemed-paid credit, is provided for dividends paid by foreign 
corporations to U.S. corporations which own at least 10 percent of the 
voting stock of the foreign corporation. Dividends to these U.S. cor- 
porations are considered as carrying with them a proportionate amount 
of the foreign taxes paid by the foreign corporation. The computation 
of the amount of the foreign taxes allowed as a deemed-paid credit in 
the case of a dividend distribution differs depending upon whether or 
not the payor of the dividend is a less developed country corporation. 

In order to prevent a taxpayer from using foreign tax credits to 
reduce U.S. tax liability on income from sources within the United 
States, two alternative limitations on the amount of foreign tax 
credits which can be claimed are provided by present law. Under 
the overall limitation, a taxpayer aggregates his income and taxes 
from all foreign countries. A taxpayer may credit taxes from any 
foreign country as long as the total amount of foreign taxes applied 
as credits in each year does not exceed the amount of tax which the 
United States would impose on the taxpayer's income from all sources 
outside of the United States. 

The alternative to the overall limitation is the per-eountrv limita- 
tion. Under this limitation, the same calculation made under the over- 
all limitation is made on a country-by-country basis. A taxpayer's 
credits from any country are limited to the U.S. tax on the amount of 
income from that country. Taxpayers are required to use the per- 
countrv limitation unless they elect the overall limitation. Once the 
overall limitation is elected, it cannot be revoked except with the con- 
sent of the Secretarv or his delegate. 

In cases where the applicable limitation on foreign tax credits re- 
duces the number of tax credits which can be used by the taxpayer to 
offset the U.S. tax liability in any one year, present law provides that 
the excess credits not used may be carried back for two years or car- 
ried forward for five years. 



4 

The significance of the present overseas operation of U.S. firms is 
indicated by the fact that the sales (other than petroleum products) 
of U.S. multinational foreign affiliates were $254 billion in 1974. The 
U.S. share of the book value of U.S. overseas affiliates in 1974 stood 
at $118.6 billion — an increase of $15 billion over 1973 — of which one- 
half represented net capital outlays from the United States and the 
other one-half represented reinvested earnings of these affiliates. Data 
on U.S. direct investment since 1966 are shown in table 1. 



TABLE 1.— U.S. DIRECT INVESTMENT ABROAD BY SELECTED INDUSTRY GROUP, 1966-74 
[In millions of dollars] 





Book 


Net 






Balance-of- 




value at 


capital 


Reinvested 




payments 




year end 


outflows 


earnings i 


Earnings 


income 2 


All areas: 












1966 _. 


51,792 


3,625 


1,791 


5,231 


3,467 


1967... 


56, 583 


3,073 


1,757 


5,522 


3,847 


1968 


61,955 


2,880 


2,440 


6,486 


4,152 


1969... 


68,201 


3,190 


2,830 


7,485 


4,819 


1970.... 


75,456 


4,281 


3,176 


8,023 


4,992 


1971 


83,033 


4,738 


3,176 


9,002 


5,983 


1972 


90, 467 


3,530 


4,532 


10,800 


6,416 


1973. 


103,675 


4,968 


8,158 


15, 940 


8,841 


19743 


118,613 


7,455 


7,508 


25, 141 


17, 678 


Petroleum: 












1966 


13,893 


787 


156 


1,482 


1,339 


1967 


15,189 


1,102 


206 


1,751 


1,559 


1968 


16,622 


1,174 


248 


1,963 


1,735 


1969 


17,720 


924 


29 


1,996 


1,997 


1970.. 


19,730 


1,492 


575 


2,405 


1,881 


1971 


22,067 


1,940 


421 


2,835 


2,457 


1972 


23,974 


1,613 


355 


3,063 


2,739 


1973... 


27,313 


1,442 


1,925 


6,128 


4,249 


1974 3... 


30,248 


1,158 


1,814 


13,513 


11,699 


Manufacturing: 












1966. 


20,740 


1,611 


918 


1,909 


950 


1967 


22,803 


1,224 


845 


1,860 


1,018 


1968 


25,160 


946 


1,357 


2,395 


1,055 


1969.. 


28,332 


1,210 


1,987 


3,071 


1,126 


1970.. 


31,049 


1,263 


1,528 


3,141 


1,605 


1971 


34,359 


1,564 


1,796 


3,517 


1,695 


1972.... 


28,325 


1,163 


2,830 


4,761 


1,910 


1973 


44,370 


1,863 


4,107 


6,674 


2,472 


1974 3... 


50,915 


2,712 


3,786 


6,498 


2,636 


Other: 












1966. 


17,160 


1,227 


717 


1,840 


1,177 


1967.. 


18,591 


746 


707 


1,912 


1,270 


1968. 


20,174 


760 


836 


2,128 


1,362 


1969 


22,149 


1,056 


814 


2,418 


1,696 


1970 


24,677 


1,527 


1,073 


2,477 


1,507 


1971. 


26,007 


1,234 


959 


2,649 


1,830 


1972 


28,168 


754 


1,346 


2,976 


1,767 


1973. 


31, 992 


1,663 


2,126 


4,137 


2,120 


1974 


37,450 


3,585 


1,907 


5,129 


3,343 



i Represents a U.S. reporter's share in the reinvested earnings of its foreign-incorporated affiliates. 

2 Includes interest, dividends, and branch earnings. 

3 Preliminary. 

Source: U.S. Department of Commerce, "Survey of Current Business" October 1975. 

The earnings, after foreign income taxes, of these foreign invest- 
ments were $25.1 billion, $11.1 billion of which represented earnings of 
U.S. branches. Of the $14.0 billion of earnings of foreign affiliates, $6.5 
billion or 46.7 percent was distributed as dividends to the U.S. share- 
holders. The net amount received by shareholders, after foreign with- 



holding taxes, was $5.85 billion. An additional $3.8 billion was re- 
ceived as interest, fees, and royalties. The composition of foreign 
source earnings is shown in table 2. 

TABLE 2— ADJUSTED EARNINGS AND RELATED ITEMS: DERIVATION AND RELATIONSHIP 
[In millions of dollars] 

1974 amount and source 

1. Earnings of incorporated affiliates 14,049 reported. 

2. Earnings of unincorporated affiliates.. 11,091 reported. 

3. Earnings 25,141 equals 1 plus 2. 

4. Gross dividends (on common and preferred stock) 6,541 equals 5 plus 6. 

5. Foreign withholding tax on dividends 691 derived. 

6. Dividends 5,850 reported. 

7. Interest 737 reported. 

8. Reinvested earnings 7,508 equals 1 minus 4 or 10 minus 9. 

9. Balance-of-payments income 17,678 equals 2 plus 6 plus 7 or 10 

minus 8. 

10. Adjusted earnings 25,186 equals 3 minus 5 plus 7 or 8 

plus 9. 

11. Fees and royalties 3,023 reported. 

12. Balance of payments receipts 20,701 equals 9 plus 11. 

13. Direct investors" ownership benefits 28,209 equals 10 plus 11. 

Source: Based on data in "Survey of Current Business*', October 1975, pp. 48 and 49. 

From the point of view of the U.S. investors, the return on this in- 
vestment in 1974 was $28.2 billion (including interest, royalties, and 
fees), an increase of $7.8 billion over 197-3. This represents a rate of 
return of 27.2 percent on the book value of the investment as of the 
beginning of 1974. 

Of the $28.2 billion of earnings in 1974. $20.7 billion represents a 
balance-of-payments inflow (receipts of income on U.S. direct invest- 
ment), while $7.5 billion is reinvested earnings. This $20.7 billion 
inflow represents a rate of return of 19.9 percent on the book value of 
investment at the end of 1973. Of the $20.7 billion inflow, $11.1 billion 
is earnings of U.S. branches, dividends account for $5.85 billion, royal- 
ties and fees account for $3.0 billion, and interest accounts for $0.7 
billion. 

Earnings and dividend payouts by type of business activity and 
area of the world are shown in table 3. As would be expected, this 
shows that a relatively high proportion of dividends are paid out of 
earnings from high-tax foreign countries. For example, the petroleum 
industry pays 75 percent of its earnings from developing countries in 
dividends. Manufacturing companies in Europe pay out 50 percent 
of their earnings. This table also shows that the worldwide dividend 
payout ratio of 40. 6 percent is increased substantially by the petroleum 
industry's practice of repatriating most of its high-tax extraction 
income. For example, the worldwide dividend payout ratio of manu- 
facturing industries alone is 39.8 percent. 

It is estimated that for 197C> corporate pre-tax foreign earnings will 
be approximately $25 billion (other than the extractive industries'). 
foreign taxes on this income will be about $10 billion (40 percent of 
earnings) and U.S. taxes will be about $2 billion (8 percent of 



09-607 



TABLE 3.— DIVIDEND PAYOUT RATIOS OF INCORPORATED AFFILIATES, 1973-74 
[In millions of dollars, or ratio] 

1973 1974 Payout ratio (gross 

• dividends/earnings) 

Gross Gross — — 

Area and Industry Earnings dividends Earnings dividends 1973 1974 

All areas 13,020 4,852 14,049 6,541 0.373 0.455 

Petroleum 3,260 1,335 4,088 2,274 .410 .556 

Manufacturing 6,584 2,477 6.279 2,493 .376 .397 

Other.. 3,175 1,049 3,682 1,774 .330 .482 

Developed countries 9,376 3,199 9,630 4,106 .341 .426 

Petroleum.... 1,596 356 1,977 796 .223 .403 

Manufacturing 5,638 2,150 5,278 2,195 .381 .415 

Other 2,142 692 2,375 1,114 .323 .469 

Canada 27567 7oT 37071 869 ^273 ^238 

Petroleum 596 144 675 162 .242 .240 

Manufacutring 1,441 432 1,774 484 .300 .273 

Other 531 125 623 223 .235 .358 

Europe 5,544 2,038 5~441 2,719 .358 .500 

Petroleum 750 176 1,078 561 .235 .520 

Manufacturing 3,464 1,393 2,887 1,439 .402 .498 

Other. 1,331 470 1,476 719 .353 .487 

Other developed 1, 265 4611 ijL18 518 7364 .453 

Petroleum. 250 38 224 74 .152 .330 

Manufacturing 734 325 618 273 .443 .442 

Other 280 98 276 171 .350 .620 

Developing countries 3,014 1,446 3,613 2,055 .480 .569 

Petroleum 1,334 840 1,701 1,278 .630 .751 

Manufacturing 945 327 1,001 297 .346 .297 

Other 735 280 912 482 .381 .529 

Latin America 1,519 527 1,597 683 .347 .428 

Petroleum 221 65 161 76 .294 .472 

Manufacturing 730 254 767 232 .348 .303 

Other 567 207 659 374 .365 .659 

Other developing 1,495 918 2,016 1,373 7614 .681 

Petroleum 1,112 773 1,539 1,201 .695 .780 

Manufacturing 215 72 234 64 .335 .274 

Other... 167 73 243 108 .437 .444 

International and unallocated 630 217 805 379 .344 .470 

Note: Details may not add to totals because of rounding. 

Source: U.S. Department of Commerce, "Survey of Current Business", October, 1975. 

2. Deferral 

Present Law 

Generally, the foreign source income of a foreign corporation is 
subject to U.S. income taxes only when it is actually remitted to the 

U.S. corporate or individual shareholders as a dividend. The tax in this 
case is imposed on the U.S. shareholder and not the foreign corpora- 
tion. The fact that no U.S. tax is imposed until and unless the income 



is distributed to the U.S. shareholders (usually corporations) is what 
is generally referred to as tax deferral. 2 

Present law, however, provides for an exception to the general rule 
of deferral under the so-called subpart F provisions of the Code. Under 
these provisions income from so-called tax haven activities conducted 
by corporations controlled by U.S. shareholders is deemed to be dis- 
tributed to the U.S. shareholders and currently taxed to them whether 
or not they actually receive the income in the form of a dividend. The 
statute refers to these types of income as "foreign base company 
income.* 7 

Prior to the Tax Reduction Act of 1975 the three categories of income 
subject to current taxation as tax haven income were foreign personal 
holding company income : sales income from property purchased from, 
or sold to. a related person if the property is manufactured and sold for 
use, consumption, or disposition outside the country of the corpora- 
tion's incorporation; and service income from services also performed 
outside the country of the corporation's incorporation for or on behalf 
of any related persons. That Act added a fourth category of tax haven 
income called foreign-base company shipping income. Under the Apt, 
the deferral of U.S. tax for shipping income received by a foreign sub- 
sidiary of a U.S. corporation is continued only to the extent that the 
profits of the shipping company are reinvested in shipping operations. 

In addition, present law provides for the current taxation of the in- 
come derived by a controlled foreign corporation from the insurance of 
U.S. risks. Foreign base company income and income from the insur- 
ance of U-Si risks are collectively referred to a9 subpart F income. 

Present law also provides, with certain exceptions, that earnings 
of controlled foreign corporations are to be taxed currently to U.S. 
shareholders if they are invested in U.S. property. In general terms. 
U.S. property is defined as all tangible and intangible property located 
in the United States. 

Prior to the enactment of the Tax Reduction Act of 1975 there were 
a number of significant exceptions to the rules providing for current 
taxation of tax haven income. By repealing these exceptions, the Tax 
Reduction Act of 1975 substantially expanded the extent to which for- 
eign subsidiaries of U.S. corporations are subject to current U.S. 
taxation on tax haven types of income. The Act repealed the minimum 
distribution exception which permitted deferral of U.S. taxation on 
tax haven types of income in cases where the foreign corporations 
distributed a minimum level of dividends to their US. shareholders. 



2 Where it is not anticipated that the income will be brought back to 
i)\o United States, for financial accounting purposes (in accounting i'ov 
the income of a consolidated groun consisting of one or more domestic 
corporations and its foreign subsidiaries) this income is often shown as 
income exempt from U.S. tax. 



8 

This provision was the main device used by multinational corpora- 
tions for avoiding taxation of their tax haven income, and its repeal 
(together with other changes referred to below) will result in the 
current taxation of virtually all tax haven income of foreign sub- 
sidiaries of U.S. corporations. 

The Act also repealed the exception in present law which permitted 
deferral of taxation in cases where the tax haven income was rein- 
vested in less developed countries. Finally, the Act modified the pro- 
vision which permitted corporations having less than 30 percent of 
their gross income in the form of tax haven income to avoid current 
taxation. The Act provided that this tax haven income is to be taxed 
currently in airy case where it equals or exceeds 10 percent of gross 
income. 3 

Issues 

The merits of the present system of deferral have been frequently 
debated in recent years. In 1962 the Administration proposed an 
almost total elimination of deferral. Congress responded by focusing 
on the abuses of tax haven activities and eliminating deferral for 
the types of income which are normally susceptible to tax haven 
arrangements, 

However, the general debate over whether to eliminate deferral com- 
pletely or to limit its use for all taxpayers has continued. No one dis- 
putes the fact that deferral permits foreign corporations controlled by 
U.S. persons to avoid or postpone paying some U.S. tax by retaining 
their earnings abroad. But whether this is appropriate in view of their 
separate organization or whether deferral constitutes a significant 
incentive for foreign investment and, if so, whether that incentive 
means more or less investment (and jobs) in the United States are still 
subjects of debate. 

House BUI 

The Ways and Means Committee decided at this time not to adopt 
any basic changes in the deferral provisions of present law. Instead, 
the committee referred the subject to a task force for further study. 

However, a number of more technical provisions relating to deferral 
and the taxation of foreign subsidiaries of U.S. corporations were 
included in the bill as it passed the House. They are set out below. 

The. definition of investments in U.S. property by controlled foreign 
corporations ( which are treated as dividends) would be limited by the 
House bill to investments in stock or obligations of a related U.S. 
person ( not including a subsidiary) and to tangible property leased to, 
or used by, su<'h related U.S. person. However, sales between a con- 

3 While the above-described provisions in the 197r> Act all resulted 
in the elimination or tightening of exceptions to the current taxation 
of tax haven income, one modification was made in the 1975 Act which 
resulted in a relaxation of those rules. This amendment provided 
that base company sales income (i.e., income from selling activities 
in a tax haven) does not include income from the sale of agricultural 
commodities which are not grown in the United States in commercially 
marketable quantities. 



9 

trolled foreign corporation and a related U.S. person which are dis- 
guised dividends would he considered as investments in U.S. property. 
The new rules would be prospective except that they would apply as of 
1969 with respect to foreign corporations owning U.S. suhsidiaries 
which invest in property situated on the U.S. Outer Continental Shelf. 
(Sec. 1021) 

The House hill eliminates the provision in present law which excepts 
U.S. shareholders of less-developed country corporations from ordi- 
nary income tax on gain from the sale of stock of those corporations (to 
the extent of their accumulated profits) . This provision would apply to 
sales after Decemher 31. 1075, with respect to earnings accumulated 
after that date. (Sec. 1022) 

An exception to the definition of foreign personal holding company 
income is added by the House bill for income on earned surplus which 
must be retained by a foreign casualty insurance subsidiary in order 
to satisfy State insurance solvency requirements as to earned pre- 
miums. This exception would apply to taxable years beginning after 
December 31, 1975. (Sec. 1023) 

The tax haven (or subpart F) provisions are modified by the House 
bill to exclude from the definition of foreign base company income 
shipping between two or more points within the country of incorpora- 
tion and registration of the ships. Also, amounts paid on unsecured 
loans by companies substantially all of whose assets consist of qualified 
investments in foreign base shipping operations would be treated as a 
reinvestment in shipping assets for purposes of subpart F. This pro- 
vision would apply to taxable years beginning after December 81, 1975. 
(^ec. 1024) m 

The definition of foreign base company sales income is amended by 
the House bill to exclude agricultural commodities which are signifi- 
cantly different in grade or type from, and which the Secretary of the 
Treasury determines after consultation with the Secretary of Agricul- 
ture are not readily substitutable for (taking into account consumer 
preferences) agricultural products grown in the United States in 
commercially marketable quantities. This provision would apply gen- 
erally to taxable years beginning after December 31, 1975. (Sec' 1025) 

3. Foreign Tax Credit 

Present Law 

As discussed above (in the Overview section), present law permits 
taxpayers subject to U.S. tax on foreign income to take a foreign tax 
credit for the amount of foreign taxes paid on income from sources 
outside of the United States. The credit is provided only for amounts 
paid as income, war profits or excess profits taxes to any foreign 
country or to a possession the Unifed States. 

The foreign tax credit is allowed not only for taxes paid on income 
derived from operations in a foreign country, but it is also allowed for 
dividends received from foreign corporations operating in foreign 
countries and paying foreign taxes. This latter credit, called the 
deemed-paid credit, is provided for dividends paid by foreign corpora- 
tions to U.S. corporations which own at least 10 percent of the voting 
stock of the foreign corporation. Dividends to these U.S. corporal ions 



10 

are considered as carrying with them a proportionate amount of the 
foreign taxes paid by the foreign corporation. 4 

The computation of the amount of the foreign taxes allowed as a 
deemed-paid credit in the case of a dividend distribution differs de- 
pending upon whether or not the payor of the dividend is a less 
developed country corporation. For less developed country corpora- 
tions the foreign taxes paid are allocated between the dividend dis- 
tribution and the portion of the earnings used to pay the foreign 
taxes. However, this omits from the U.S. tax base the portion of the 
earnings used to pay the foreign tax. As a result, where the foreign 
tax is less than the U.S. tax (but above zero), this gives an advantage 
to dividend income over income subject to the full United States tax. 
For developed country corporations the earnings used to pay the for- 
eign tax allowed as a credit are included in the distribution base and 
the credit for foreign taxes paid is based upon all the earnings, in- 
cluding the amount paid as foreign taxes, and not merely the portion 
paid as a dividend. 

To prevent a taxpayer from using foreign tax credits to reduce 
U.S. tax liability on income from sources within the United States, 
two alternative limitations on the amount of foreign tax credits 
which can be claimed are provided by present law. Under the overall 
limitation, the amount of foreign tax credits which a taxpayer can 
apply against his U.S. tax liability on his worldwide income is limited 
to the ratio of his taxable income from sources outside the United 
States (after taking all relevant deductions) to his worldwide taxable 
income. Under this limitation, a taxpayer may credit taxes from any 
foreign country as long as the total amount of foreign taxes applied 
as a credit in each year does not exceed the amount of tax which the 
United States would impose on the taxpayer's income from all sources 
without the United States. 

The alternative to the overall limitation is the per-country limita- 
tion. Under this limitation the same calculation made under the over- 
all limitation is made on a country-by-country basis. The allowable 
credits from any single foreign country cannot exceed the ratio of 
taxable income from that country to worldwide taxable income. Tax- 
payers are required to use the per country limitation unless they elect 
the overall limitation. Once the overall limitation is elected, it cannot 
be revoked except with the consent of the Secretary or his delegate. 

4 These rules for the deemed-paid credit applv to distributions to a 
domestic corporation from a first-tier foreign corporation in which the 
domestic corporation is a 10-percent shareholder and to distributions 
from a second-tier or third-tier foreign corporation (through a first- 
tier foreign corporation), as long as each receiving corporation in the 
chain of dividend distributions is a 10-percent shareholder in the cor- 
poration making the distribution. However, distributions originating 
from a foreign corporation that is more than three tiers beyond the 
domestic corporate shareholder do not carry with it any deemed-paid 
foreign tax credit. 



11 

In computing taxable income from any particular country or from 
all foreign countries for purposes of the tax credit limitations, all 
types of income are included as well as the deductions which relate 
to that income and a proportionate part of the deductions unrelated to 
any specific item of income. Thus, for example, income from capital 
gains is included in the computation of the credit as well as the deduc- 
tions allocable to those gains (e.g.. the 50-percent exclusion of capital 
gains for individuals). 5 

In cases where the applicable limitation on foreign tax credits re- 
duces the amount of tax credits which can be used by the taxpayer 
to offset U.S. tax liability in any one year, present law provides that 
the excess credits not used may be carried back for two years or carried 
forward for five years. However, if a person using the per-country 
limitation in any year elects subsequently to use the overall limitation, 
no carryovers are permitted from years in which the per-country 
limitation was used to years in which the overall limitation was 
elected. 

The Tax Reduction Act of 1975 prohibits the limitation on the 
foreign tax credit on income from oil and oil-related activities from 
being calculated under the per-country method. Instead, this income 
(and any losses) are computed under a separate overall limitation 
which applies only to oil-related income. Any losses from oil-related 
activities are to be "recaptured." in future years through a reduction in 
the amount of allowable foreign tax credits which can be used to offset 
subsequent foreign oil-related income. 

In addition, the Tax Reduction Act of 1975 requires that the amount 
of any taxes paid to foreign governments which will be allowed as tax 
credits on foreign oil extraction income is limited to 52.8 percent of 
that income (after deductions) in 1975, 50.4 percent in 1976 and 50 
percent in subsequent years. 

Issue 

(a) Credit limitations. — It has been noted that the two alternative 
limitations on foreign tax credits present different advantages for 
different taxpayers. Some contend that the use of the per-country 
limitation permits a U.S. taxpayer who has losses in a foreign country 
to obtain what is in effect a double tax benefit. They point out that since 
the limitation is computed separately for each foreign country, branch 
losses in any foreign country do not have the effect of reducing the 
amount of credits allowed for foreign taxes paid in other foreign coun- 
tries on other income. Instead, they note that these losses reduce U.S. 
taxes on U.S. source income by decreasing the worldwide taxable in- 
come on which the U.S. tax is based. In addition, they note when the 
business operations in the loss country become profitable in a subse- 

5 However, an exception is provided for interest income if that in- 
come is not derived from the conduct of a banking or financing busi- 
ness, or is not otherwise directly related to the active conduct of a trade 
or business in the foreign country. Such interest income and the taxes 
paid on it are subject to a separate per-country limitation to be calcu- 
lated without regard to the other foreign income of the taxpayer. 



12 

quent tax year, a credit will be allowed for the taxes paid in that 
country. Thus, they contend that if the foreign country in which the 
loss occurs does not have a net operating loss carryforward provision 
(or some similar method of using prior losses to reduce subsequent tax* 
able income), the taxpayer receives a second tax benefit when income 
is derived from that foreign country because no U.S. tax is imposed on 
the income from that count ry (to the extent of foreign taxes paid on 
that income) even though earlier losses from that country have reduced 
U.S. tax liability on U.S. source income. Hard mineral companies. 
Avhich generally incur substantial losses from new mines, are currently 
the primary beneficiaries of the per-country computation. 

The overall limitation does not allow this same advantage to be 
gained from foreign losses, because these losses are offset against in- 
come from other foreign countries rather than against U.S. income. 
However, in spite of the fact that in most cases foreign losses do not 
reduce U.S. tax liability under the overall limitation, most companies 
that operate in more than one country elect to use this limitation be- 
cause it is substantially less complex and does offer other advantages 
for companies which do not incur substantial losses. Under the overall 
limitation, a company averages together all of its foreign income and 
taxes from all foreign countries. Thus, it has been noted that an indi- 
vidual or company which annually pays taxes in one foreign country 
at a rate higher than the U.S. tax rate (and thus would have some tax 
credits disallowed under the per-country limitation) is able to average 
those taxes with any taxes which might be paid at lower rates in other 
foreign countries when applying the overall limitation. The result is 
that a taxpayer can use more of the taxes paid in high tax countries 
as credits against U.S. tax on foreign income under the overall limita- 
tion if he also has income from relatively low-tax countries against 
which the highly taxed income can be averaged. 6 

(b) Lex* developed country corporations. — Under present law, the 
amount of dividends from a less developed country corporation in- 
cluded in income by the recipient domestic corporation is not increased 
(i.e., grossed up) by the amount of taxes which the domestic corpo- 
ration receiving the dmdend is deemed to have paid to the foreign 
government. Instead the amount of taxes is reduced by the ratio of 
the foreign taxes paid by the less developed country corporation to its 
pretax profits. 

It is contended that the failure to gross up the dividend by the 
amount of the foreign taxes attributable to the dividend results, in 
effect, in a double allowance for foreign taxes. It is argued that the 
amount paid in foreign taxes not only is allowed as a credit in com- 
puting the U.S. tax of the corporation receiving the dividend, but 
also is alloAved as a deduction (since the dividends can only be paid 

(! For example, a company earning $100 each in countries A & B and 
paying $00 in tax in A on that income and $30 in tax in B could use 
all $90 in foreign taxes under the overall limitation (the limitation 
would be 48 percent of $200 or $9C>). Under the per-country limitation 
onlv $48 of the taxes paid to country A would be creditable, thus 
limiting total credits to $78. 



13 

out of income remaining after payment of the foreign tax). 7 The 
result, it is noted, is that the combined foreign and U.S. tax paid by 
the domestic corporation is less than 48 percent of the taxpayers 
income in cases where the foreign tax rate of the less developed 
country corporation is lower than the -18-percent U.S. corporate tax 
rate (but not zero or lower). It is also pointed out that in cases where 
the foreign tax rate exceeds 48 percent, the dividend does not bring 
with it all the foreign taxes that were paid and thus the size of foreign 
tax credit carryover is reduced. 

(c) Treatment of capital gains — A number of questions hai'e been 
raised with respect to the present treatment of capital gains income 
under the foreign tax credit as a result of the fact that capital gains 
are taxed differently than ordinary income. In many cases the source 
of income derived from the sale or exchange of an asset is determined, 
if the asset is personal property, by the place of sale. It is pointed out 
that in these cases, taxpayers presently can often exercise a choice 
of the country from which the income from the sale of tangible per- 
sonal property is to be derived. 

Since many foreign countries do not tax an}' gain from sales of 
personal property, and most countries that do tax these gains do not 
apply the tax to sales by foreigners, it is argued that the present sys- 
tem permits taxpayers to plan sales of their assets in such a way so 
that the income from the sale results in little or no additional foreign 
taxes and yet the amount of foreign taxes usable as a credit against 
U.S. tax liability is increased. 

Another aspect of present capital gains taxation that is of concern 
to some is that the credit limitations are not adjusted to reflect the 
lower tax rate on capital gains income received by corporations. 8 Under 

7 For example, assume that a foreign country imposes a 30-percent 
tax on $1,000 of income. If the foreign corporation earns $1,000 as a 
less developed country corporation in that country, a distribution by 
that corporation of the remaining $700 to its U.S. parent corpora- 
tion would result in $700 income to the U.S. parent. The parent's 
U.S. tax would be $336 before allowance of a foreign tax credit. In 
calculating the foreign tax credit, the $300 amount of forei<rn taxes 
paid would be reduced by 300/1000 to $210. The $210 could' then be 
credited against U.S. tax liability of $336, leaving a net liability of 
$126. Thus, combined U.S. tax and foreign tax liability on the orig- 
inal $1,000 of income would be $426 ($300 foreign taxes plus $126 
U.S. tax), not the $480 which would be paid at a 48-percent rate. 

If that same foreign corporation earning $1,000 were not a less de- 
ve"!oped country corporation, the entire $1,000 would be included in 
the parent corporation's income if it received a dividend of $700 
which would carry with it foreign taxes of $300. In this case, the 
U.S. tax before credit would be $480. The entire $300 of foreign taxes 
would be credited, leaving a U.S. tax liability of $180. The com- 
bined U.S. tax and foreign tax liabilities would be $480. 

8 A similar problem exists to a much lesser extent for capital gains 
income of individuals under the alternative tax (sees. 1201 (b) and 
(c) ). 



6Q r,07— 7G- 



14 

present law, corporations having a net long-term capital gain in most 
instances pay only a 30-percent rate of tax on that gain. But for pur- 
poses of determining foreign source and worldwide income in the 
limiting fraction of the foreign tax credit limitation, income from 
long-term capital gains is treated the same as ordinary income (i.e., 
as if it were subject to a 48-percent rate of tax) . 9 Similarly, a taxpayer 
who has a capital gain income from U.S. sources and has foreign 
source income that is not capital gain income does not receive a full 
credit for the amount of U.S. tax attributable to foreign source 
income. 10 

House Bill 

The Ways and Means Committee decided not to adopt any new 
limitation on the amount of allowable foreign tax credits. Instead, 
the committee referred the subject to a task force for further study. 

However, a number of important provisions providing for changes 
in the method of computation of the foreign tax credit were included 
in the House bill. These are outlined below. 

Under the House bill the per country limitation on the foreign 
tax credit would be repealed in general for taxable years ending after 
December 31, 1975. 

.V 3-year postponement of this rule (until taxable years ending after 
December 31, 1978) would be provided by the House bill for domestic 
mining corporations engaged in the extraction of minerals outside the 
United States or its possessions for less than 5 years, that have sus- 
tained losses in at least 2 of these years, that have 80 percent of their 
gross receipts from the sale of such minerals, and that have made 
commitments for substantial expansion of their foreign mineral 
extraction activities. 

The repeal of the per country limitation provided by the House bill 
does not applv to income derived from sources within the possessions 
of the United States. ( Sec. 1031 ) 

Foreign losses which arise on an overall basis would under the 
House bill be required to be offset against U.S. income when, and to the 
extent, foreign income is earned in future years. This provision would 
apply to losses incurred in taxable years beginning after December 31, 



9 For example, if a corporation has worldwide income of $20 mil- 
lion, $10 million of which is ordinary income from sources within the 
United States and $10 million of which is income from the sale of an 
asset from sources without the United States, that corporation is al- 
lowed a foreign tax credit equal to one-half (10/20) of his U.S. tax 
liability, even though only $3 million of the $7.8 million in U.S. tax 
liability is attributable to foreign source income. Present law thus 
favors the taxpayer with a foreign source capital gain since his U.S. 
tax on U.S. ordinary income of $10 million is not $4.8 million but is 
$3.9 million. 

10 For example, if such a taxpayer had $10 million of U.S. source 
capital gain and $10 million of foreign ordinary income, the foreign 
tax credit limitation would limit the credit to $3.9 million even though 
he would be liable for $4.8 million of U.S. tax on his foreign source 
income. 



15 

1975. However, this recapture rule would not apply to losses incurred 
m a possession of the United States, in taxable years beginning before 
January 1, 1981. (Sec. 1032) 

Dividends received by U.S. shareholders from less-developed coun- 
try corporations would under this House bill be required to be "grossed 
up- r by the amount of taxes paid to less-developed countries for pur- 
poses of computing the foreign tax credit and the related foreign 
source taxable income. (Sec. 1033) 

Any capital gain from property sold outside of the country in which 
a company does most of its business (or outside the country of residence 
of the individual) under the House bill would not be treated as foreign 
source income for purposes of the foreign tax credit limitation, if no 
substantial foreign tax has been paid on that income. New rules would 
be provided for netting foreign source capital gains and losses with 
domestic source capital gains and losses in computing the foreign tax 
credit limitation. Amounts to be included in the limitation would be 
adjusted for the lower corporate tax rate on capital gains income. 
(Sec. 1034) 

Finally, under the House bill a carryback would be allowed to any 
taxable year ending in 1975, 1976, or 1977 for certain extraction taxes 
which would otherwise be disallowed with respect to foreign oil and 
gas extraction income. (Sec. 1035) 

4. Amendments Primarily Affecting Individuals 

A. Exclusions for Income Earned Abroad 

Present Law 

U.S. citizens are generally taxed by the United States on their 
worldwide income, with the provision of a foreign tax credit for 
foreign taxes paid. However, U.S. citizens who work abroad may 
exclude from their income up to $20,000 of earned income for periods 
during which they reside outside of the United States for 17 out of 
18 months or during the period they are bona fide residents of foreign 
countries (sec. 911). In the case of individuals who have been bona 
fide residents of foreign countries for three years or more, the exclu- 
sion is increased to $25,000 of earned income. Currently, approxi- 
mately 100,000 U.S. citizens file returns excluding income from rax 
under this provision. These exclusions do not apply to amounts paid 
by the U.S. Government to its employees who work abroad. 

A separate exclusion from gross income (sec. 912) is provided for 
certain statutory allowances paid to civilian employees of the United 
States Government who work in foreign countries and, in certain in- 
stances, in the States of Hawaii and Alaska and in the territories and 
possessions of the United States. Some of the allowances would, in the 
absence of the specific exclusion, nevertheless be excluded from income, 
in whole or in part, under other provisions of the tax laws. Others 
are amounts for which the employee may be entitled to a deduction 
in computing taxable income. 

Issues 

The present exclusions have been opposed on the grounds that they 
result in a U.S. income tax savings for an individual involved in 



16 

those cases where the excluded income of the U.S. citizen is not taxed 
at all by any foreign country or is taxed at a lower foreign rate 
than that otherwise imposed by the United States. Those with this 
view consider this treatment unfair to others who reside in this coun- 
try and pay the regular income tax. 

It is also argued that additional income tax savings can be obtained 
if foreign taxes are paid on the excluded income because those taxes 
can be credited against any U.S. tax on anv foreign source income 
not qualifying for the $20,000 (or $25,000) exclusion. It is noted that 
the effect of this is to provide a foreign tax credit on income which 
has not been subjected to double taxation and thus to provide in effect 
a double benefit. 

Questions have also been raised as to the appropriateness of the 
exclusion for allowances paid to U.S. Government employees serving 
abroad on much the same grounds as the objections to the exclusions 
for private employees. 

Bouse Bill 

The $20,000 exclusion (or in certain instances, $25,000) for income 
earned abroad by U.S. citizens living or residing abroad would be 
phased out under the House bill over a 4-year period, by lowering the 
exclusion by $5,000 (or $6,250) each year. However, the $20,000 exclu- 
sion would be retained for employees of U.S. charitable organizations 
(section 501(c) (3) organizations). In addition, employees working on 
construction projects (other than oil or gas wells) would continue 
to receive the $20,000 exclusion for taxable years beginning in 1976, 
1977, and 1978. In those cases where the full exclusion is not available, 
a deduction of up to $1,200 would be provided for elementary and sec- 
ondary school expenses of dependents of U.S. taxpayers employed out- 
side the United States. An exclusion from gross income would also be 
provided for amounts paid for municipal-type services furnished in a 
foreign country by an employer on a nondiscriminatory basis. Present 
law would also be modified to allow a foreign tax credit to individuals 
claiming the standard deduction. These provisions would apply to tax- 
able years beginning after December 31, 1975. (Sec. 1011) . 

The House bill does not deal with the exclusion of allowances paid to 
governmental employees serving abroad. It was decided to defer any 
action on this provision until an inter-agency task force of the Execu- 
tive branch could complete a study on the governmental allowances 
which they were then preparing. 

B. U.S. Taxpayers Married to Nonresident Aliens 

Present Law 

Under present law, a husband and wife may file a single income tax 
return even though one of the spouses has no gross income or deduc- 
tions. However, this joint return may not be made if either the hus- 
band or the wife at any time during the taxable year is a nonresident 
alien. 

Issues 

It has been pointed out that the inability of a husband and wife to 
file a joint return where one of them is a nonresident alien has re- 



17 

suited in the possibility of a heavier tax burden being placed upon 
this group of taxpayers than other married taxpayers. For example, 
evenlhough a joint return is not allowed, the spouse who files a tax 
return is required to use the rate brackets of married individuals fil- 
ing separately. In addition, these married individuals cannot obtain 
the benefits of the 50-percent maximum tax on earned income because 
married taxpayers must file a joint return in order to obtain the bene- 
fits of that provision. 

House Bill 

U.S. taxpayers married to nonresident aliens would under the House 
bill be permitted to file joint returns with their spouse if an election 
is made by both taxpayers to be taxed on their worldwide income and 
if the taxpayer makes available the necessary books and records. This 
provision would apply to taxable years ending on or after Decem- 
ber 31, 1975. Community property laws for income tax purposes would 
not apply to taxpayers married to nonresident aliens whether or not 
they make this election. This provision would apply to taxable years 
beginning after December 31, 1975. (Sec. 1012) . 

C. Treatment of Foreign Trusts and Excise Tax on Transfers of 
Property to Foreign Persons 

Present Law 

Under present law, the income of a trust is taxed basically in the 
same manner as the income of an individual, with limited exceptions 
(sec. 642). Just as nonresident alien individuals are generally taxed 
only on their U.S. source income other than capital gains and on their 
income effectively connected with a U.S. trade or business (and not 
on their foreign source income), so any trust which can qualify as 
being comparable to a nonresident alien indmdual is generally not 
taxed on its foreign source income. If a trust is taxed in a manner 
similar to nonresident alien individuals, it is considered (under sec. 
7701(a) (31) ) to be a foreign trust. 11 

If a U.S. taxpayer is a beneficiary of a foreign trust, distributions 
to him are generally taxed in the same manner as are distributions to 
a beneficiary of a domestic trust. Any accumulation distributions are 
subject to throwback rules, under which the amount of tax to be 
paid by the beneficiary is determined by the tax bracket of the bene- 
ficiary in the year the trust originally earned the income rather than 
the year the income was distributed. However, in the case of an ac- 
cumulation distribution by a foreign trust which was created by a 



11 The Internal Revenue Code does not specify what characteristics 
must exist before a trust is treated as being comparable to a nonresident 
alien individual. However, Internal Revenue Service rulings and court 
cases indicate that this status depends on various factors, such as the 
residence of the trustee, the location of the trust assets, the country 
under whose laws the trust is created, the nationality of the grantor, 
and the nationality of the beneficiaries. If an examination of these fac- 
tors indicates that a tnist has sufficient foreign contacts, it is deemed 
comparable to a nonresident alien individual and thus is a foreign 
trust. 



18 

U.S. person, any capital gains income earned by the trust is treated as 
distributed pro rata with other income (and taxed at favorable capi- 
tal gains rates to the beneficiary), while in the case of these distribu- 
tions by domestic trusts, capital gains income is treated as distributed 
only after all other income is distributed. 

In addition to the above provisions which govern the taxation of 
foreign trusts, present law imposes (sec. 1491) an excise tax of 27% 
percent on certain transfers of property to foreign trusts, as well as to 
foreign corporations (if the transfer is a contribution of capital) 
and to foreign partnerships. Under present law, the excise tax is im- 
posed on transfers of stock or securities to such an entity by a U.S. 
citizen, resident, corporation, partnership or trust. The amount of 
the excise tax is equal to 2TV2 percent of the amount of the excess of 
the value of the stock or securities over its adjusted basis in the hands 
of the transferor. 

Issued 

The rules of present law permit U.S. persons to establish foreign 
trusts in which funds can be accumulated free of U.S. tax. In addition, 
the funds of these foreign trusts are generally invested in countries 
which do not tax interest and dividends paid to foreign investors, and 
the trusts generally are administered through countries which do not 
tax such entities. Thus, these trusts generally pay no income tax any- 
where in the world. Although the beneficiaries are taxed (and the 
throwback rules are applied) upon any distributions out of these 
trusts, nevertheless it is contended that it is unfair to permit a grantor 
by using a foreign trust to provide a tax-free accumulation of income 
while the income remains in the trust. 

Little information is known a'bout the value of assets held in foreign 
trusts, but some experts have concluded that $5 to $10 billion would not 
be an unreasonable estimate. Many believe this trend was accelerated 
by the introduction of legislative proposals to tax the earnings of for- 
eign trusts to the grantor of the trust. This point of view assumes that 
the acceleration occurred because of the belief that any new rules tax- 
ing the grantors of foreign trusts would not apply to trusts established 
prior to the enactment of the legislation. It has been reported that 
based upon this expectation, one law firm established over 200 trusts 
for its clients. 

Finally, some believe the excise tax on certain transfers to foreign 
trusts and other foreign entities may not be effective in preventing 
U.S. taxpayers from transferring appreciated property to foreign 
trusts or other entites without payment of a full capital gains tax. 
It is noted that the excise tax of 27i/£ percent of the amount of appre- 
ciation is less than the maximum capital gains tax on individuals 
(which can be as high as 35 percent). Furthermore, the excise tax pro- 
vision has been interpreted to exclude transfers to foreign entities to 
the extent that the entity provides some consideration to the transferor. 
It is argued that this enables a U.S. taxpayer to transfer appreciated 
stock to a trust established by him and receive in return from the trust 
a private annuity contract or other deferred payment obligation. In 



19 

any such case, it is noted that the transferor will pay U.S. tax on the 
gam only as the deferred payments are received and will have the 
benefit of the tax-free accumulation of income from the property trans- 
ferred (or from the proceeds of any sale of the property by the trust). 

House Bill 

U.S. grantors of foreign trusts with U.S. beneficiaries under the 
House bill would be taxed currently on the income of these trusts 
under the grantor trust rules of present law. This provision would 
apply to trusts created after May 21, 1974 and to transfers of property 
to foreign trusts after May 21, 1974, in taxable years ending after 
December 31, 1975. (Sec. 1013) 

In all other cases U.S. beneficiaries of foreign trusts would under 
the House bill pay interest charges on the U.S. taxes on any accumula- 
tion distributions which are subject to U.S. tax. The interest charge 
would apply to distributions made after December 31, 1975. (Sec. 101-1) 

Finally, under the House bill the excise tax on transfers of stocks 
and securities to foreign entities would be extended to transfers of all 
oilier types of property. This tax would apply only to the unrealized 
appreciation. The rate of this tax would be increased from 27% to 
35 percent. These changes would apply to transfers made after 
October 2, 1975. (Sec. 1015) 

5. Money or Other Property Moving In or Out of the United States 

A. Investments by Foreigners in the United States 

Present Law 

Present law provides, in general, that interest, dividends and other 
similar types of income of a nonresident alien or a foreign corpora- 
tion are subject to a 30 percent tax on gross amount paid, if such 
income or gains are not effectively connected with the conduct of a 
trade or business within the United States (sees. 871 (a) and 881). This 
tax is generally collected through withholding by the person making 
the dividend or interest payment to the foreign recipient of the income 
(sees. 1441 and 1442). For this reason the tax is commonly referred to 
as a withholding tax. However, in the case of interest, a number of 
exemptions have been provided from this 30-percent tax on the gross 
amount. Interest from deposits with persons carrying on the banking 
business are exempt (sees. 861(a)(1)(A) and 861(c)). Any interest 
and dividends paid by a domestic corporation which earns less than 20 
percent of its gross income from sources within the United States is 
also not subject to the 30 percent tax (sees. 861(a) (1) (B) and 861(a) 
(2) (A)). 

In addition to the above exemptions provided in the Internal Reve- 
nue Code, the United States has a number of tax conventions in effect 
which provide for either an exemption or a reduced rate of tax for 
interest and dividends paid to foreign persons if the income is not 
effectively connected with the conduct of a trade or business within the 
United States. 



20 

Issues 

For a number of reasons many believe that interest and dividends 
paid to nonresident aliens and foreign corporations should be exempt 
from U.S. tax. First, it is argued that the exemption on bank deposits 
should be retained since amounts on deposit in bank accounts could be 
very easily transferred out of the United States in to foreign bank 
accounts, ft is also argued that a U.S. exemption for bond issues of U.S. 
corporations sold to foreign lenders would lessen the administrative 
burden and cost to U.S. borrowers without resulting in any significant 
inroad on the revenues since most of these issues are exempt today. Fur- 
ther it is argued that a broad exemption covering all portfolio interest 
income would increase the supply of capital available to U.S. bor- 
rowers and make U.S. borrowing competitive with foreign borrowing 
which often is eligible for an exemption from tax. 

House Bill 

Under the House bill, the present exemption from the 30-percent 
withholding tax which applies to foreign deposits held in U.S. banks 
(which under present law would expire on December 31, 1976) is 
made permanent, (sec. 1041) 

B. Treatment of Reorganizations Involving Foreign Corporations 

Present Law 

Present law provides that certain types of exchanges relating to 
the organization, reorganization, and liquidation of a corporation 
can be made without recognition of gain to the corporation involved 
or to their shareholders. However, when a foreign corporation is in- 
volved in certain of these types of exchanges, tax-free treatment is 
not available unless prior to the transaction the Internal Revenue 
Service has made a determination that the exchange does not have 
as one of its principal purposes the avoidance of Federal income taxes. 
This determination is made by issuing a separate ruling for each 
transaction. The required determination must be obtained before the 
transaction in all cases unless the transaction involves only a change 
in the form of organization of a second (or lower) tier foreign sub- 
sidiary with no change in ownership. 

In 1968, the Internal Revenue Service issued guidelines 12 as to 
when favorable rulings ''ordinarily-* would be issued. As a condition to 
obtaining a favorable ruling with respect to most transactions, the 
section 367 guidelines require the taxpayer to agree to include certain 
items in income (the amount to be included is called the section 367 
toll charge). The amount required to be included in income generally 
reflects untaxed accumulated earnings and profits (in the case of 
transfers of property into the United States) , or the immediate poten- 
tial earnings from liquid assets or the untaxed appreciation from 

12 Rev. Proc. 68-23, 1968-1 Cum. Bull. 821. 



21 

passive investment assets (in the case of transfers of property out of 
the United States). 13 

In addition to section 367, section 1248 provides for the imposition 
of a U.S. tax on accumulated profits earned abroad when they are 
repatriated to the United States in cases where gain is recognized on 
the sale or exchange (or redemption) of stock of a controlled foreign 
corporation held by a U.S. person owning 10 percent or more of the 
voting stock. This provision is designed to terminate deferral on 
the unrepatriated earnings of a foreign subsidiary when the earnings 
are indirectly repatriated through the sale or liquidation of the 
subsidiary. 

Issues 

Many taxpayers have raised questions as to the operation of section 
367 and section 1248. First, it is stated that the advance ruling require- 
ment often results in an undue delay for taxpayers attempting to con- 
summate perfectly proper business transactions. Second, it is indicated 
that a number of cases have arisen where a foreign corporation was 
involved in an exchange within the scope of the section 367 guidelines 
without the knowledge of its U.S. shareholders, and thus no request 
for prior approval was made. As a result, the shareholders were taxed 
on the exchange despite the fact that a favorable ruling would clearly 
have been issued by the Internal Revenue Service had it been requested 
prior to the transaction. 

The third area where questions have been raised in the present 
administration of section 307 concerns situations where the IRS re- 
quires a U.S. shareholder to include certain amounts in income as a 
toll charge even though there is no present tax avoidance purpose but. 
rather, only the existence of a potential for future tax avoidance. In 
certain of these cases the Internal Revenue Service only has the option 
either of collecting an immediate tax or of collecting no tax at all 
since the IRS has no authority to defer payment of the tax until the 
time that the avoidance, actually arises, except by entering into a 
closing agreement with the taxpayer. 

13 For example, if a domestic corporation transfers property to a 
foreign subsidiary corporation (a transaction otherwise accorded iax- 
free treatment under section $51), the transaction will be given a 
favorable ruling only if the domestic corporation agrees to include in 
its gross income for its taxable year in which the transfer occurs an 
appropriate amount to reflect realization of income or gain with 
respect to certain types of assets (e.g.. inventory, accounts receivable, 
and certain stock or securities) transferred to the foreign corporation 
as part of the transfer. If the transaction involves the liquidation of 
a foreign corporation into a domestic parent, a favorable ruling will 
be issued if the domestic parent agrees to include in its income as a 
dividend for the taxable year in which the liquidation occurs the 
portion of the accumulated earnings and profits of the foreign cor- 
poration which are properly attributable io the domestic corporation's 
slock interest in the foreign corporation. 



22 

The necessity for obtaining the satisfaction of the IES that no tax 
avoidance is involved in a transaction results in a taxpayer having the 
choice of modifying a transaction as suggested by the IRS or not going 
through with the transaction. Presently, there is no opportunity for 
a taxpayer who disagrees with the IES determination to obtain a court 
review even if the taxpayer believes that the IES has acted arbitrarily. 
Many would like to resolve this problem by affording taxpayers who 
wish to challenge an IES determination the right to consummate the 
transaction and have the issue resolved in the courts. 

Finally, the section 1248 provision terminating deferral on the sale 
of a foreign subsidiary applies only to taxable sales or exchanges. In 
other situations it is pointed out that, for example, where the stock 
of a foreign subsidiary is sold pursuant to a liquidation plan, the 
section does not apply and no ordinary income tax is paid on the 
untaxed foreign earnings. 

House hill 

The House bill eliminates the requirement of present law under 
section 367 that an advance ruling from the IES be obtained for re- 
organization-type transactions involving foreign corporations. For 
transactions which are solely foreign or which involve the transfer of 
property into the United States, the House bill provides that the IES 
is to draft regulations by January 1, 1978, specifying the treatment of 
these transactions. For transfers of property out of the United States, 
individual rulings would still be required but these rules could be re- 
quested up to 183 days after the beginning of the transaction. In addi- 
tion, these rulings would be subject to Tax Court review. Finally, the 
provision of present law which taxes as ordinarily income the sale of 
stock in a foreign subsidiary (to the extent of accumulated earnings) 
would be extended to apply to nontaxable transfers of stock (Code sec- 
tions 311, 336, and 337) . 

These provisions would apply generally to exchanges beginning- 
after October 9, 1975, and to sales, exchanges and distributions taking- 
place after such date. The provision relative to Tax Court review 
would apply with respect to pleadings filed with the Tax Court after 
the date of enactment of this legislation but only with respect to 
exchanges beginning after October 9, 1975. (Sec. 1042) 

C. Contiguous Country Branches of Domestic Insurance 

Companies 

Present law 

Under present law, a domestic mutual life insurance company is 
subject to tax on its worldwide taxable income. If the company pays 
foreign income taxes on its income from foreign sources it is allowed 
a foreign tax credit against its otherwise payable U.S. tax on foreign 
source income. 

Issue 

Since the beginning of this century. U.S. mutual life insurance 
companies have been engaged in the life insurance business in Canada. 
At the, present time, the tax imposed by the United States on the op- 
erations of Canadian branches of U.S. mutual life insurance com- 



23 

panies generally exceeds the tax imposed by the Dominion of Canada 
and its provinces. 

The income of the companies from their Canadian operations is 
derived generally by the issuance of policies insuring Canadian risks 
and the investment income from the policyholder reserves on the 
Canadian risks and any surplus. Quite often the investments of the 
Canadian branch are in Canadian securities. A separate branch account 
is maintained by the life insurance companies under which the various 
income, expense, asset, reserve and other items that relate to Canadian 
policyholders are segregated on the books of the company. The sepa- 
rate branch accounting system is used for purposes of establishing 
premiums and policyholder dividend rates based upon the separate 
mortality and earnings experience of the Canadian branch. 

The income earned by the Canadian branch inures solely to the 
benefit of these Canadian policyholders and is reflected either by divi- 
dends paid to them, reductions in the cost of insurance, or increases in 
the size of the reserves and surplus with respect to Canadian policy- 
holders. Thus, it is argued that the additional cost to the 
company resulting because U.S. tax liability exceeds Canadian 
income tax liability on the Canadian branch profits falls primarily 
upon the Canadian policyholders, since it reduces the reserves and 
surplus available to the Canadian policyholders. It is contended that 
this tax treatment makes it more difficult to issue mutual life insurance 
policies in Canada. 

Similar tax problems are faced by U.S. stock life companies who 
compete in Canada for business under terms that are substantially 
the same as mutual companies. 

House Bill 

Mutual life insurance companies maintaining separate operations in 
countries contiguous to the United States would under the House bill 
be permitted to treat these operations as if carried on through a foreign 
subsidiary. A mutual company would be treated as having transferred 
its assets to such a branch operating in the contiguous country and 
would be subject to the normal tax requirements (of Code section 367) 
regarding transfers of property out of the United States for tangible 
property assets except that losses would be netted in determing the 
gain from these assets. In addition, stock life insurance companies 
would be permitted to transfer the assets of their foreign branch opera- 
tions in contiguous countries to foreign subsidiaries under these same 
section 367 rules. This provision would apply to taxable years begin- 
ning after December 31, 1975. (Sec. 1043) 

D. Transitional Rule for Bond, etc., Losses of Foreign Banks 

Present Lata 

The Tax Reform Act of 1969 (PL. 91-17-2) eliminated the preferen- 
tial treatment accorded to certain transactions of financial institutions 
involving corporate and government bonds and other evidences of in- 
debtedness. Previous to that these financial institutions were allowed 
to treat net gains from these transactions as capital gains and to de- 
duct the losses as ordinary losses. The 1969 Act provided parallel 
treatment to gains and losses pertaining to (lies- transactions by (rent- 



24 

ing net gains as ordinary income and by continuing the treatment of 
net losses as ordinary losses. The ordinary income and loss treatment 
provided under the 1969 Act was also applied to corporations which 
would be considered banks except for the fact that they are foreign 
corporations. Previous to the 1969 Act, these corporations had treated 
the above-described transactions as resulting in either capital gains 
or capital losses. 

issue 

Some of the corporations which would be considered banks except 
for the fact that they are foreign corporations had capital loss carry- 
overs predating the 1969 Act. However, any post-1969 gains realized 
by these corporations resulting from the sale or exchange of a bond, 
debenture, note, or other evidence of indebtedness is accorded ordinary 
income treatment. Thus, these corporations are left with capital loss 
carryforwards which, under present law, cannot be applied against 
any gains resulting from the same type of transactions which previ- 
ously generated such losses. 

House Bill 

Foreign banks would be provided the same transition rule as applies 
presently to domestic banks with respect to the sale or exchange of a 
bond, debenture, note or certificate or other evidence of indebtedness. 
This provision would apply generally to taxable years beginning after 
July 11, 1969. (Sec. 1044) 

6. Special Categories of Corporate Tax Treatment 

A. Western Hemisphere Trade Corporations 

Present Law 

Under present law, domestic corporations called ''Western Hemi- 
sphere Trade Corporations'' (WHTCs) are entitled to a deduction 
which may reduce their applicable corporate income tax rate by as 
much as 14 percentage points below the applicable rate for other do- 
mestic corporations. 14 

A domestic corporation must meet three basic requirements to qual- 
ify as a WHTC. First, all of its business (other than incidental pur- 
chases) must be conducted in countries in Xorth, Central or South 
America or in the West Indies. Second, the corporation must derive at 
least 95 percent of its gross income for the 3-year period immediately 
preceding the close of the taxable year from sources outside the United 
States. Third, at least 90 percent of the corporation's income for the 
above period must be derived from the active conduct of a trade or 
business. The above requirements are intended to insure that the cor- 
poration is engaged in an active trade or business outside the United 
States, but within the Western Hemisphere. 

Issues 

Questions have been raised as to whether there is any longer any 
basis for continuing the preferential tax treatment provided WHTCs. 



14 Tho deduction fser. 9-2*2 of the Code) is equal to taxable income 
multiplied by 14 over the corporate tax and surtax rates. 



25 

It is noted that in any event the benefit of this treatment is no longer 
significant in many cases because the taxes which are now imposed by 
the Western Hemisphere Trade countries approach or equal those im- 
posed in the United States. It is also pointed out that under the broad 
interpretation given the WHTC provisions by the Service, corpora- 
tions can often obtain the benefits of the provisions for goods manu- 
factured outside the Western Hemisphere by causing title to the goods 
to pass within the Western Hemisphere. Chiefly, however, it is argued 
that this is discriminatory treatment which no longer serves any na- 
tional purpose. 

House Bill 

The provision of present law which permits a 14-percent lower tax 
rate for Western Hemisphere Trade Corporations would under the 
House bill be phased out over a 5-year period, according to the follow- 
ing table : 

The percentage 
For a taxable year beginning in — would be — 

1976 11 

1977 8 

1978 5 

1979 2 

Thus, the Western Hemisphere Trade Corporation provisions would 
be repealed with respect to taxable vears beginning after December 31. 
1979. (Sec. 1052) 

B. Corporations Conducting Business in Possessions 

Present Law 

Under present law. corporations operating a trade or business in a 
possession of the United States are entitled to exclude from gross in- 
come all income from sources without the United States, including for- 
eign source income earned outside of the possession in which they con- 
duct business operations, if they meet two conditions. First, 80 percent 
or more of the gross income of the corporation for the 3-year period 
immediately preceding the close of the taxable year must be derived 
from sources within a possession of the United States. Second, 50 per- 
cent of the gross income of the corporation for the same 3-year period 
must be derived from the active conduct of a trade or business within 
a possession of the United States. 

Any dividends from a corporation which satisfies these requirements 
are not eligible for the intercorporate dividends received deduction. 
This deduction, however, is allowed if the corporation did not sat- 
isfy these requirements in the current and preceding taxable year. In 
addition, since a corporation meeting the requirement? of section 031 
is a domestic corporation, no gain or loss is recognized to a parent 
corporation if it liquidates a possessions corporation (under section 
332). 

The exclusion of possessions income applies to corporations conduct- 
ing business operations in the Commonwealth of Puerto Rico and all 
possessions of the United States (Guam, the Canal Zone, and Wake 
Island) except the Virgin Islands. The exclusion also applies to busi- 
ness operations of individuals in possessions but not to Puerto Rico or 
to the Virgin Islands and Guam. 



26 

Issues 

The special exemption provided in conjunction with investment 
incentive programs established by possessions of the United States, 
especially the Commonwealth of Puerto Rico, has been used as an 
inducement to U.S. corporate investment in active trades and businesses 
in Puerto Rico and the possessions. Under these investment programs, 
little or no tax is paid to the possessions for a period as long as 10 to 15 
years and no tax is paid to the United States as long as no dividends 
are paid to the parent corporation. 

Because no current U.S. tax is imposed on the earnings if they are 
not repatriated, it is pointed out the amount of income which accumu- 
lates over the years from these business activities can be substantial. 
It is also noted that the amounts which may be allowed to accumulate 
are often beyond what can be profitably invested within the possession 
where the business is conducted. As a result, corporations generally in- 
vest this income in other possessions or in foreign countries either 
directly or through possessions banks or other financial institutions. In 
this way, it is claimed possessions corporations not only avoid U.S. tax 
on their earnings from businesses conducted in a possession, but also 
avoid U.S. tax on the income obtained from reinvesting their business 
earnings abroad. 

It is a strong^ held view of the Government of Puerto Rico that 
the possessions investment incentives play a key role in keeping invest- 
ments in the possessions competitive with investments in neighboring 
countries. It points out that the U.S. Government imposes upon Puerto 
Rico, for example, various requirements such as minimum wage re- 
quirements and requirements to use U.S. flag ships in transporting 
goods between the United States and Puerto Rico. These requirements 
substantially increase the labor, transportation and other costs of es- 
tablishing business operations in Puerto Rico. Thus, without signifi- 
cant local tax incentives that are not nullified by the U.S. tax law, it is 
argued that the Commonwealth of Puerto Rico would find it quite 
difficult to attract investments by U.S. corporations. 

However, it is recognized that investing the business profits of these 
possessions corporations outside of the possession where the business 
i.s being conducted does not contribute to the economv of that posses- 
sion either by creating new jobs or by providing capital to others to 
build new plants and equipment. Accordingly, it is suggested that 
while it may bo appropriate to provide preferential treatment for in- 
vestment in the possessions as contrasted to investment in a foreign 
country, it is not appropriate to provide a preference for income 
earned from investments outside of the possession. The denial of a 
dividends received deduction to the U.S. parent corporation tends to 
cause the possessions corporation to invest earnings abroad until liqui- 
dation (usually upon termination of the local tax exemption), at which 
time the earnings can be returned to the United States tax free. These 
profits derived outside of the possession could be made subject to U.S. 
tax if the possessions Corporation were given the alternative of re- 
turning the profits to the United States prior to liquidation without 
payment of any U.S. tax. 

A second set of difficulties under present law stems from the rela- 
tionship of the possessions corporation provisions to the provisions 



27 

relating to the filing of consolidated tax returns. Domestic corpora- 
tions which are affiliated usually file a consolidated tax return. Among 
the benefits of a consolidated tax return is the opportunity to offset the 
losses of one corporation against the income of other corporations. A 
corporation which is entitled to the benefits of the possessions 
corporation exclusion may not participate in the filing of a consoli- 
dated return. However, the courts have determined that possessions 
corporations may join in the filing of consolidated returns in years in 
which they incur losses. As a result, it is argued these corporations can, 
in effect, obtain a double benefit. Xot only is the possessions and other 
foreign source income of these corporations excluded from U.S. tax- 
able income, but losses of possessions corporations can, by filing a con- 
solidated return, reduce U.S. tax on the U.S. income of related corpora- 
tions in the consolidated group. 

House Bill 

The tax treatment of possessions corporations would be modified 
by the House bill by providing a new tax credit for such corporations 
in lieu of the income exclusion provided under present law. The tax 
credit would equal the U.S. tax attributable to a corporation's income 
from a possessions trade or business and from qualified possessions 
investments. Other income of a possessions corporation would be sub- 
ject to U.S. tax. U.S. corporations receiving dividends from possessions 
corporations would be eligible for the 85- or 100-percent dividends- 
received deduction. Corporations would qualify as possessions corpo- 
rations only if they elect for a period of 10 years to remain in that 
status. These provisions would apply to taxable years beginning after 
December 31. 1075. (sec. 1051) 

C. China Trade Act Corporations 
Present Lai& 

Under present law. a China Trade Act Corporation ("CTA corpora- 
tion") and its shareholders are entitled to special tax benefits. Under 
these provisions, a CTA corporation is subject to the same tax rates 
as a domestic corporation, but. upon meeting certain requirements, is 
allowed a special deduction which can completely eliminate any in- 
come subject to tax (sec. 941) . 

The special deduction is allowed against taxable income derived 
from sources within Formosa and Hong Kong in the proportion which 
the par value of stock held by residents of Formosa. Hong Kong, the 
United States, or by individual citizens of the United States, wherever 
resident, bears to the par value of all outstanding stock. Tims, where 
all the shareholders of the CTA corporation are either U.S. citizens or 
residents of Hong Kong. Formosa, or the United States, and all of the 
corporation's income is derived within Hong plong and Formosa, 
the special deduction would equal and thereby eliminate the taxable 
income of the corporation. 

The special deduction is limited by a requirement that a dividend 
must be paid in an amount at least equal to the amount of Federal tax 
that would be due were it not for the special deduction. The "special 
dividend" tnust be paid to stockholders who. on the last day of the tax- 
able year, were resident in Formosa. Hong Kong, or were either resi- 



28 

dents or citizens of the United States. For example, if the taxable in- 
come before the special deduction were $100,000 in 1974, the special 
dividend would have to equal at least $41,500 (22 percent of the first 
$25,000 plus 48 percent of the remaining $75,000). In this example, 
upon payment of the special dividend of $41,500, the CTA corporation 
deriving all of its taxable income from sources within Hong Kong and 
Formosa ($100,000) would be entitled to a special deduction in an 
amount equal to its taxable income, i.e., $100,000. The special dividend 
deduction enables the CTA corporation to operate free of tax. 15 

In addition special benefits are accorded to the shareholder's of a 
CTA corporation. Dividends paid by a CTA corporation to share- 
holders who reside in Hong Kong or Formosa are not includable in the 
gross income of the shareholder (sec. 943). This applies to all divi- 
dends paid to Hong Kong or Formosa resident shareholders, regard- 
less of whether they are regular or special dividends. 

Issues 

It is contended that the combination of benefits granted to CTA 
corporations and their shareholders is unprecedented. For example, if 
in a given year a CTA corporation, whose shareholders are U.S. citi- 
zens residing in Hong Kong or Formosa, has $500,000 of taxable in- 
come and pays a special dividend of at least $233,500 to its share- 
holders, neither the corporation nor its shareholders will incur any 
U.S. tax liability, whereas a domestic corporation and its shareholders 
in this situation (assuming marginal tax brackets of 50 percent for 
the shareholders) would incur respective U.S. tax liabilities of $233,500 
and $116,750. The tax savings to the CTA corporation and its share- 
holders in the above example would be $350,250. If the balance of the 
earnings of the CTA corporation were paid out, the tax savings would 
be even greater. 

It is argued that the original purpose of the China Trade Act, that 
of expanding trade with China, is no longer being served by the xory 
favorable tax advantages it provides. Moreover, there are innumerable 
U.S. companies currently trading in Hong Kong and Formosa with- 
out the extensive tax benefits provided by the China Trade Act. 

House Bill 

The provisions of present law permitting special tax treatment for 
China Trade Act Corporations and their shareholders would be phased 
out over a 4-year period, according to the following table: 

The percentage 
For a taxable yea)- beginning in — reduction would he - 

1976 25 

1977 50 

1978 75 

Thus, the China Trade Act Corporation provisions would be repealed 
with respect to taxable years beginning after December 31, 1978. 
(Sec. 1053) 



15 The CTA corporation is not entitled to the foreign tax credit (sec. 
942) but is entitled to the doduction of all foreign taxes paid with re- 
soect to taxable income derived from sources within Hong Kong or 
Formosa (sec. 164). 



29 
7. Domestic International Sales Corporations (DISCs) 

Present Law 

Present law provides for a system of tax deferral for a corporation 
known as a Domestic International Sales Corporation, or a "DISC'', 
and its shareholders. Under this tax system, the profits of a DISC are 
not taxed to the DISC but are taxed to the shareholders of the DISC 
when distributed to them. However, each year a DISC is deemed to 
have distributed income representing 50 percent of its profits, thereby 
subjecting that income to current taxation in the shareholders hands. 
In this way the tax deferral which is available under the DISC pro- 
A'isions is limited to 50 percent of the export income of the DISC. 

To qualify as a DISC, at least 95 percent of the corporation's assets 
must be export related and at least 95 percent of a corporation's gross 
income must arise from export sale or lease transactions and other 
export-related activities (i.e., qualified export receipts). Qualified ex- 
port receipts include receipts from the sale of export property, which 
generally means property such as inventory manufactured or pro- 
duced in the United States and held for sale for direct use, consump- 
tion or disposition outside the United States. The President has the 
authority to exclude from export property any property which he 
determines (by Executive order) to be in short supply. However, 
energy resources such as oil and gas and depletable minerals are auto- 
matically denied DISC benefits under the Tax Eeduction Act of 1975. 
That Act also eliminated DISC benefits for products the export of 
which are prohibited or curtailed under the Export Administration 
Act of 1969 by reason of scarcity. 

If a DISC fails to meet the qualifications for any reason, the DISC 
provisions provide for an automatic recapture of the DISC benefits 
received in previous years. This recapture is spread out over the num- 
ber of years for which the corporation was qualified as a DISC but 
may not exceed 10 years. 

Issues 

Those who favor the retention of the DISC provisions believe that 
DISC was enacted to enable U.S. manufacturers to increase their ex- 
ports and that DISC has accomplished what it set out to do. Since 
the enactment of DISC in 1971, exports have increased from $43 bil- 
lion to $107 billion for 1975. This is an increase of 250 percent. Al- 
though recognizing that other factors have played a significant role in 
the increase of U.S. exports, advocates of DISC conclude that a sig- 
nificant role in this increase has also been played by DISC. 

It is argued that DISC increases U.S. exports in a number of ways. 
First, it enables U.S. manufacturers to reduce their prices to meet 
foreign competition. This assistance is necessary to counter the variety 
of ways in which foreign competitors receive export assistance from 
their governments (such as the rebate of value added taxes). Second, 
to the extent prices are not lowered, DISC provides increased funds 
to U.S. exporters to finance their export sales. Third. DISC provides 
funds to U.S. companies to expand their production facilities (which 
increases U.S. employment) for export sales. Finally, the existence of 
the DISC program indicates the importance which the Federal Gov- 
ernment places upon export sales. Its repeal could be taken as a signal 



30 

that the Federal Government no longer considers exports to be 
important. 

Advocates for the retention of DISC argue that increasing export 
sales is beneficial to the U.S. economy in a number of ways. First, it is 
argued that export sales create employment in U.S. industry which 
would be lost but for the export sales. Additionally, it is argued that 
increased exports helps the U.S. balance of payments by providing 
the foreign currency which is essential to enable U.S. industry and 
U.S. consumers to import high-priced foreign oil. 

It is also argued that without DISC it would quite often be neces- 
sary to manufacture abroad rather than in the United States, since 
DISC is designed to equalize the treatment with U.S. firms with for- 
eign subsidiaries. Manufacturing abroad would result in incomes taxes 
paid to foreign governments rather than the United States ; employ- 
ment for foreign individuals rather than for U.S. individuals; and the 
loss of positive balance of payments inflow from export sales. Thus, 
it is argued that the repeal of DISC would result in a loss of jobs and 
revenue. 

On the other hand the drastic changes in economic circumstances 
have prompted some individuals to call for the elimination of DISC. 
They take the position that DISC has not been particularly successful 
in stimulating exports and that the international economic setting is 
substantially different from what it was at the time the DISC was 
adopted. Consequently, they argue that the usefulness of the DISC 
provision is substantially less than it Avas at the time of its adoption. 

Opponents of DISC suggest that the tax benefits from this treat- 
ment are small relative to the volume of merchandise sold abroad and 
thus are unlikely to have any major effect on sale. At the same time 
they note that major decreases have taken place in prices due to flexible 
exchange rates and suggest that this is the major cause of export in- 
creases rather than the DISC provisions. 

They also question the economic rational of having: an export incen- 
tive during a period of flexible exchange rates. During a period of fixed 
exchange rates (as when DISC was enacted) they suggest the incen- 
tive could be used in part as a method for companies to reduce the 
dollar pi-ice of their exports in the face of a fixed value of the dollar, 
thus making our exports relatively more attractive. During a period 
of flexible exchange rates, however, any increase in U.S. exports will 
be reflected in greater demand for dollars and therefore a higher 
exchange rate price for dollars in terms of other currencies. This 
higher dollar value would make U.S. exports somewhat more expen- 
sive, offsetting in part the initial increase in exports. Furthermore, 
the higher dollar value means that foreign goods will be relatively 
eheaper and consequently the United States would tend to import 
more. 

Questions have also been raised as to whether the employment effects 
of export stimulation are overemphasized. To the extent imports are 
increased by the higher dollar value resulting from DISC, it is argued 
i ".S. corporations competing with imported goods are worse off and 
may lose jobs. 




31 3 1262 07125 7470 



House Bill 

The House bill eliminated from DISC treatment products sold for 
use as military equipment and also agricultural products not in 
surplus in the United States. 

For taxable years beginning after December 31, 1975, DISC benefits 
receipts would be allowed only to the extent that the DISC'S income 
for the year exceeds 75 percent of its base period in receipts. From 
1976 through 1980, the base period is to be average DISC receipts of 
the corporation in the years 1972, 1973. and 1974. Beginning in 1981 
this base period is to move one year forward each year. Companies 
whose total DISC benefits are less than $100,000 per year are not to be 
subject to the new base period method of computation, but instead 
may calculate their DISC benefits as provided by present law. 

Taxpayers for whom DISC benefits were repealed under the Tax 
Reduction Act of 1975 are to continue to receive DISC benefits for 
exports made pursuant to binding contracts written after the com- 
pany's DISC was established but before March 18, 1975, but only if 
the contracts have both fixed price and fixed quantity requirements. 
This binding contract rule is to apply for 5 years from March 18, 
1975. The provision in the Tax Reduction Act of 1975 providing that 
DISC tax treatment is not to be available if the commodity involved 
is a natural resource subject to the allowance of cost depletion is 
changed to eliminate DISC benefits for those items subject to the 
allowance of percentage depletion. 

Finally, the House bill contains two provisions relating to quali- 
fication and recapture of DISC income in those cases where export 
products lose their eligibility for DISC treatment. First, a DISC 
may continue to loan its accumulated DISC earnings as a qualified 
producer loan if the loan would otherwise qualif}^ under the rules that 
were applicable before the DISC benefits were eliminated for the 
goods which the DISC exported if the parent continues to export 
those goods. Second, the recapture of accumulated DISC earnings (be- 
cause of DISC disqualification) are to be spread out over a period 
equal to two years for each year that the DISC was in existence (up 
to a maximum of 10 years), instead of being one year (up to a maxi- 
mum of 10 years) provided under present law. (Sec. 1101)